Eric Barden learned a lesson six years ago, when he ignored the biggest companies and his Texas Capital Value & Growth Fund fell more than 20 percent as U.S. stocks surged. He has trounced the Standard & Poor's 500-stock index ever since.
Barden and co-manager Mark Coffelt started out favoring smaller companies a decade ago and changed the strategy after losing most of their assets in 1999, when the S&P 500 rallied for a fifth straight year and the Nasdaq composite index soared 86 percent. They now invest in companies of all sizes.
"In 1999, we looked like some of the stupidest managers on the planet," Barden said from his office in Austin. "We fought the market the whole way" as larger companies led the rally, he said.
These days, "we have the entire investment universe available to us, which is an incredibly potent competitive advantage," he said. The fund's holdings have ranged from U.S. drugmaker Johnson & Johnson, with a market value of $192 billion, to so-called micro-cap stocks such as Aldila Inc., a designer of graphite golf-club shafts, valued at $126 million.
The $74 million fund's biggest holdings include Caremark Rx Inc., the second-largest U.S. manager of pharmacy benefits; Korea Electric Power Corp., the utility that supplies almost all of South Korea's electricity; and an exchange-traded fund that tracks Morgan Stanley Capital International Inc.'s Austria Index.
Hovnanian Enterprises Inc. and Laboratory Corp. of America Holdings, companies Barden and Coffelt view as inexpensive relative to their growth potential, also are among their investments.
The Texas Capital fund beat the S&P 500 by an annual average of 23 percentage points from 2000 to 2004. This year, the fund has risen 9.2 percent, exceeding the benchmark's 1.2 percent gain after reinvested dividends.
During the past five years, the fund has risen at an average annual rate of 19 percent, according to data compiled by Bloomberg. That ranks eighth of 92 funds that focus on companies with relatively low price-to-earnings ratios and market values of less than $5 billion. RS Partners Fund is the top performer in the group, with a 25 percent annualized return.
The Texas Capital fund invests in some of the smallest publicly traded companies and compares itself to the Russell 2000 Index and the S&P 500. The five-year return is about quadruple the 5 percent average gain of the Russell 2000, whose members have a median market value of $592 million.
The fund has an advantage because its assets under management are smaller than those of competitors, said Andrew Gogerty, a mutual fund analyst at Morningstar Inc. in Chicago.
"It affords them the ability to dive down into micro-caps if they want and gives them the flexibility to move from giant to small without impacting the market," he said. The other funds in the Bloomberg rankings have assets of at least $100 million.
Texas Capital Value's managers met in 1995. Barden, now 32, was close to receiving his bachelor's degree from the University of Texas at Austin and wanted work experience before deciding whether to go to law school or business school. His broker put him in touch with Coffelt, now 50, a Texas native who was running First Austin Capital Management Inc. and planning to start his first mutual fund.
"I offered my services in return for an educational experience, and he took me up on it," said Barden, a Kansas native who attended Texas on a debating scholarship. "It was apparent that his investment philosophy synced with my personal investment approach."
Six months later, after Barden graduated from Texas with a double major in economics and government, he was hired full time, and he helped start the fund.
Both managers said 1999, the last year of a five-year rally led by technology companies, was their most trying period. Cisco Systems Inc., the world's largest producer of equipment to link computers, more than doubled that year. Yahoo Inc., which runs the most widely visited Web site, more than tripled.
"The market was operating in a fashion that was incomprehensible to me," Barden said. "It was a speculative tech bubble." The fund, which lost two-thirds of its assets that year, had consumer stocks such as Abercrombie & Fitch Co. and home builders such as Standard Pacific Corp. instead of computer-related companies, he said.
Coffelt, a graduate of the University of Pennsylvania's Wharton School, said the fund "went from a pretty rigid style to a highly flexible style" after the decline.
In response, the managers developed research systems to narrow a universe of more than 8,000 stocks to fewer than 600, Coffelt said. The strategy accounts for the market's momentum, a criterion they didn't consider in 1999. Each manager picks stocks independently based on his own research and analysis.
Caremark, based in Nashville, and Coventry Health Care Inc., an insurer based in Bethesda, were the fund's biggest holdings as of June 30. The iShares MSCI Austria Index Fund was third, followed by Korea Electric, based in Seoul.
Barden favors Hovnanian, New Jersey's largest builder, which is benefiting from growth in the housing market. He began buying shares in 2001, when they more than doubled. They have since surged fivefold, leading him to reduce the fund's stake.
Earnings at the Red Bank, N.J.-based company will increase 32 percent this year, to $7.05 a share, according to the average analyst estimate in a Thomson Financial survey.
Coffelt likes Laboratory Corp., the second-largest U.S. medical laboratory company. Analysts in a Thomson survey project earnings growth of 15 percent for fiscal 2005, to $2.81 a share, for the Burlington, N.C.-based company.
Barden said he pays more attention to company fundamentals and Coffelt focuses more on quantitative analysis, a dichotomy that has worked for them. "We learn from each other's successes as well as mistakes," Barden said.